When I crossed over from W-2 employee to being self-employed and co-founded our investment firm, I was excited about the plethora of business retirement plans that I now had at my disposal.
One such option (which ended up being the one I went with) is the Simplified Employee Pension (SEP) IRA. A SEP IRA and a traditional IRA are the contribution limits imposed. The contribution rules for the SEP are allowable for the lesser of either 25% of your self-employment net earnings; or $69,000.
The other similarity between a SEP IRA and a traditional IRA is the distribution rules. The distribution of both the IRA account and SEP IRA must be taken at some point but some distributions are elective and others will be forced.
Penalties and taxes that are applied to both distributions will be dependent on the age of the owner at the time of distribution as well as the tax deductions of the assets during the contribution time.
Before the age of 59 ½, any early withdrawal will be subjected to a 10% penalty. This is in addition to the federal income tax imposed.
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Exceptions for Deferral of the 10% Early Withdrawal Penalty
Below are some exceptions for deferral of the 10% early withdrawal penalty.
Money Used for Medical Expenses
If a withdrawal is made to pay non-reimbursable medical costs, any amount going over 10% of the adjusted gross income of the individual for the year will not incur the early withdrawal penalty.
Money Used to Pay Medical Insurance
A penalty-free distribution can be used to pay medical insurance for the individual, their spouse, and any dependents as long as the distribution is necessary due to job loss.
This can happen if unemployment benefits have been paid by state or federal agencies for 12 consecutive weeks.
The person would receive distributions during the year they received unemployment compensation or for the next year. Also, the person would receive distributions no later than 60 days after reemployment occurs.
Money Used for a Disability
When an individual becomes disabled before the age of 59 ½ and takes a distribution from their IRA account, the distribution does not incur a penalty.
Proof of the disability from a licensed medical provider must show that either a mental or physical condition prevents the individual from finding gainful employment.
Money Used to Purchase a First Home
Monies can be withdrawn penalty-free if the funds are used to purchase, build, or remodel a first home for the account holder, their spouse, child, grandchild, or parent of the account holder.
The monies must be used to pay eligible acquisition costs before the end of the 120th day of receiving the distribution of funds.
The funds withdrawn for a first home purchase also can’t be more than $10,000 during the account owner’s lifetime for single individuals. Married couples can withdraw a lifetime total of $20,000.
Money Used for Tax Levy
Monies in an IRA account can be levied by the IRS if taxes are owned which result in a distribution amount. Any distribution amounts will not incur a penalty fee.
Money Used for Educational Expenses
If monies are being used to fund the expenses of higher education of the owner or the dependents of the owner, the amounts will be penalty-free.
Education expenses that are eligible include tuition, books, supplies, and school fees as part of a requirement for enrollment in an eligible college, university, vocational school, and other post-secondary school participating in student aid programs through the Department of Education.
Beneficiary Distributions
For the SEP program, penalty-free distributions are made from a series of equal payments and must last five years or until the owner reaches the age of 59 ½, whichever time period is longer.
For IRA beneficiaries, if the owner of the account dies before having reached age 59 ½, the distribution amounts for the beneficiary are not penalized.
Exceptions for Deferring the 10% Early Withdrawal Penalty
| Exception | Description |
|---|---|
| Medical Expenses | • Penalty-Free Withdrawals for Medical Costs Exceeding 10% Of Annual Income |
| Medical Insurance | • No Penalty for Insurance Due to Job Loss After 12 Weeks of Unemployment Benefits |
| Disability | • Penalty Waived for Disability-Related Distributions With Medical Proof |
| First Home | • Penalty-Free Withdrawals for First Home Expenses Within 120 Days |
| Tax Levy | • IRS Levy for Owed Taxes Doesn’t Incur a Penalty on Withdrawals |
| Educational Expenses | • Penalty-Free Withdrawals for Education Costs Like Tuition, Books, and Fees |
| Beneficiary Distributions | • Sep Program: Penalty-Free Equal Payments for Five Years or Until Age 59 ½ • IRA Beneficiaries: No Penalties if Owner Dies Before Age 59 ½ |
Bottom Line
If you want to take an early distribution from your SEP IRA, be sure to consult with your tax preparer before making the withdrawal. The rules above are general and can be affected by your personal tax situation.
